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Investing: Roth 401k or Traditional 401k?

Have you heard the news? Starting in 2006, a Roth-like option for 401(k) plans will be introduced. They'll probably be known as either a "Roth 401(k)" or a "Roth ERSA". They're created by 26USC§402A and so might logically be called "402A" plans, just as 26USC§401(k) created the "401(k)". (Note that it's §402A, not §402(a), which is something different.)

I haven't thoroughly immersed myself in the details. If you want to, go ahead — you'll find them in the laws cited above, and in IRS REG-152354-04. (Have I mentioned lately that I love the Internet?) The basic idea is simple. With a 401(k), contributions are tax-deductible but when you retire, your distributions will be taxed as ordinary income. With a 402A, contributions aren't tax-deductible but when you retire, your distributions will be tax-free. For both, income within the account is not taxed.

The question of whether the 401(k) or 402A is superior is fundamentally the same question of whether a Traditional IRA or a Roth IRA is superior. The answer, of course, is "it depends". It depends on taxes, because the fundamental difference between the options is when they're taxed — when you put money in, or when you take money out.

The 401(k)/402A contribution limit for 2006 will be $15,000. For a typical person with a combined income tax rate of 34% (25% Federal + 9% Oregon state), a maxed-out 402A contribution will cost $22,727.27 out of their pocket — 34% taxes on $22,727.27 are $7,727.27, leaving $15,000 for the account. Given the same starting funds of $22,727.27, a maxed-out 401(k) contribution will be $15,000, with the remaining $7,727.27 taxed at 34%, leaving $5,100 for regular non-tax-advantaged investment.

As if you couldn't sense it coming, yes, it's time to play with a spreadsheet! It's also time for the obligatory disclaimer: I am not a financial advisor or planner or consultant or <insert adjective here>… but I do play one on the internet. :)

The spreadsheet is configured for a 20-year investment period over which to compare the 401(k) and 402A options. There's also a section for saving exclusively in a non-tax-advantaged account. For simplicity, the spreadsheet assumes the rate of return from investments is fixed, and that taxes on non-tax-advantaged investments are also fixed. The 401(k)/402A contribution limit is allowed to vary over time for expected inflation, and income tax rates may also be varied over time.

The default values in the spreadsheet have unchanging income taxes. Look at the results. After 20 years, and assuming that by then you're old enough to be eligible to take distributions, the Roth-like 402A wins. (I'll address the Required Minimum Distribution in a minute — patience!) It's important to see that the entire advantage is due to the taxes on the non-tax-advantaged accounts. If you ignore those taxes (set cell B5 to 0), all three options have equal returns!

A brief side note: You can minimize taxes on the non-tax-advantaged account by adopting a very-long-run buy-and-hold strategy. Prefer capital gains to dividends, because they can compound without being taxed. This mimics the benefits of the tax-advantaged accounts. (The spreadsheet doesn't model this.) Of course, it's tough to maintain a balanced portfolio with this approach. It's not practical to never sell anything. Being a totally passive investor just for the tax benefit is not a good idea. And it still wouldn't enable the non-advantaged account to match the 402A. Avoiding the taxation on the compounding doesn't avoid the eventual taxation on the gain. The 402A avoids taxation on both.

Set cell B5 back to 15%, and we'll continue.

Before you decide to put all your money in a 402A, we need to talk about the Required Minimum Distribution. Eventually the government requires you to withdraw funds from a 401(k) — they won't let you avoid taxes forever. There's a table that explains how much you'll be required to distribute from your 401(k).

One of the potential benefits of a 401(k) is that you might be in a lower income tax bracket when you retire, especially if you have no significant income other than Social Security and your 401(k) distribution. By taking distributions as slowly as possible, you can try to stay in low tax brackets. The spreadsheet doesn't model this at all — it liquidates the 401(k) all at once. And even here it gets it wrong, because you certainly wouldn't qualify for the 25% federal tax bracket if you did that! The spreadsheet understates the taxes for a liquidation. But you wouldn't liquidate anyway — you'd take the minimum distribution allowed.

A person who is 70 (the first year distributions are required) must distribute 1/27.4th of their 401(k). From a balance of $773,839.96, this is $28,242.33. This is just under today's 25% federal income tax bracket. Assuming you'd have Social Security income also, you wouldn't be able to benefit from being in a lower tax bracket at retirement. (The table is configured so that the distributions are approximately equal each year.) Additionally, the spreadsheet only models 20 years of contributions. If you were an über-investor and contributed the maximum for 50 working years, you'd have $9.4 million and the minimum distribution alone would be over $340,000, putting you in today's maximum (35%) federal income tax bracket. In general, the more you invest in the 401(k), the more likely you won't be in a lower tax bracket when you start taking distributions.

While a 401(k) requires distributions, a 402A doesn't. For the long-lived, this is an advantage for the 402A because more earnings from compounding during old age will be sheltered from taxation. (The spreadsheet doesn't model this.)

Another factor to consider is your expectation of income tax rates in the future. It's difficult to predict decades into the future, of course, but personally I'm very comfortable estimating that income taxes will be higher in the future than they are today. Today's enormous budget deficits, and the future's spending for Social Security and especially Medicare, make me very pessimistic about future tax rates. Enter a 2% rate of tax increases into cell C3 and see what changes. The income tax rate after 20 years rises to 50%. The 401(k), if distributed all at once, is worse even than the non-tax-advantaged account! This occurs because all of the 401(k) money was taxed at 50%, but much of the non-tax-advantaged account was taxed in earlier years at lower rates. (Again, the spreadsheet isn't modeling 401(k) required minimum distributions, so this is a hasty comparison.)

At this point, you're probably ready to give up on your 401(k) and switch to a 402A as quickly as possible. Not so fast. The 401(k) has a saving grace: Different states have different income tax structures. You can move. Oregon has a high income tax but no sales tax. Washington has no income tax but a high sales tax. What if I move to Washington when I retire? Set cell C3 back to 0% and then set cell C29 to 25%. This goes back to unchanging tax rates and models a move from Oregon to Washington, decreasing my taxes 9%. Now the 401(k) has the edge over the 402A! This should also be intuitive — lower taxes in retirement favor the 401(k), lower taxes while contributing favor the 402A.

What am I personally planning to do? My hunches lean toward a 1% rate of increase in income taxes (cell C3) and a 10% tax differential between Oregon and Washington when I retire. With C29=C27-10%, the 401(k) is better by a slim margin. When I expand the spreadsheet for the correct number of years before I take distributions, the difference is less than 1%. It would probably be better to avoid the expense of moving to Washington. Plus, I'd feel safer in a 402A where I wouldn't need to worry about future tax rates. Further, using the 402A obviates the need to maintain a non-tax-advantaged account as with the 401(k), where my money would be vulnerable to increases in investment-related taxes.

Having made some numerical projections, I feel pretty good about the 402A. Now I'll have to check with my employer to see if they're planning to offer them at all. :)

Upon reflection it seems like the spreadsheet is under-done. I talked about several things that it doesn't model. But I'd rather not go through the effort to add them. Besides, if you want an analysis that gets all the details right, you ought to go to a professional anyway.

One last thought — if the United States switches to a national consumption tax, this whole analysis has to be defenestrated.

Tiny Island